Every decade or so, Congress passes a major energy bill. The Energy Policy Act of 2005 is the latest in that series, and was a little late, since the last was the EPAct of 1992. But EPAct 2005 did not create an ideal strategic energy policy for the nation, and its seventeen titles resemble nothing so much as a comprehensive to-do list. It did, however, legislate many important new policies, and it was a major improvement over the proposed legislation that had moved forward earlier in the session.

Through EPAct 2005, Congress entrusted the Federal Energy Regulatory Commission (FERC) with important new powers and responsibilities. This delegation represented a marked turn-around in its attitude toward the Commission. Following the California energy crisis of 2000-2001 and the Enron implosion, Congress lost confidence in the Commission's ability to understand and oversee the energy markets for which it was responsible and treated it as a useful receptacle for some of the blame. But FERC's new Chairman Kelliher demonstrated considerable legislative skills to build on the market oversight and investigation capability that developed at the Commission during Chairman Wood's administration. The EPAct 2005's assignments recognize this.

FERC completed more than fifteen final rules and other assignments within the first six months of the Act's passage. At the first anniversary of EPAct 2005, the Commission issued a scorecard on its performance, which is summarized here:

As a result FERC announced that it had met "every deadline set for the Commission in EPAct."

Despite the important changes embodied in the EPAct2005 legislation, they did not provide a fundamentally new vision of the Commission's role, which is to provide "reliable, affordable energy through reliance on competition and effective regulation." The commission's strategic plan gives primacy to promoting a robust energy infrastructure, of key importance to investors. The other strategic goals now focus on preventing the exercise of market power. Moreover, chairman Kelliher has made it clear that Congress, through EPAct 2005, re-affirmed its commitment to competition in energy markets, especially wholesale power markets.

It is important for those in project finance, especially those who may have been active in the energy markets at a different time, to realize that the tools now at FERC's disposal give it important new authority, including civil and criminal penalty authority.

Table 1 illustrates the broad extent of the enhancements. Project developers and financiers need to change their practices to assure compliance with the changed regulatory environment.

Areas of additional regulatory risk under EPAct 2005

Moreover, the Commission has signaled its willingness to accept the current hybrid market situation, with its mix of traditional utility regulation and organized markets. This complex national market system will create opportunities, as well as risks.
FERC has important new responsibilities regarding:
• power system reliability
• wholesale power and natural gas market integrity
• mergers and acquisition
• energy infrastructure.

Power system reliability

When the Northeast Blackout of 14 August 2003 hit, the Commission's responsibilities were minor, if there were any. Nevertheless, it elected to step into a messy policy void because someone had to take responsibility for determining what had happened and why. FERC and the US Department of Energy (DOE) ultimately came to share responsibility (with Canadian officials) for examining and reporting on this blackout.

The 2003 blackout confirmed the need for mandatory reliability standards for the power industry. The North American Electric Reliability Council (NERC) had repeatedly urged Congress to legislate mandatory standards, and FERC had supported those policy recommendations. Rather than immediately pass emergency legislation, however, the unique logic of Washington was applied and mandatory electric power reliability provisions, about which there was great consensus, were held to be the anchor for a comprehensive energy bill. The logic was that it was so important to pass reliability laws that Congress would work through all the thorny issues surrounding comprehensive energy legislation if that were the only way to get mandatory reliability in place.

To implement EPAct 2005, FERC created a new reliability unit, staffed with up to 30, finalized rules to certify an Electric Reliability Organization (ERO) and certified NERC as this ERO, and mandates that the ERO perform a self-assessment three years after certification and after that at five-year intervals. The Commission will delegate responsibility for enforcing mandatory compliance with the reliability standards to the ERO. The ERO will delegate certain oversight, enforcement, and reporting functions to regional reliability organizations. The entire system of mandatory, enforceable reliability standards will operate under FERC's authority in the United States. Canadian and Mexican authorities will have analogous roles.

Broadly, FERC has stated that it will allow the ERO to develop proposed standards that balance reliability principles and implementation features "appropriately." The commission, however, will not defer to the ERO or others regarding the anticipated effects of proposed reliability standards on competition. Interestingly, there is no clear delegation within FERC for this important integrative analysis function – will it lie in the hands of the Reliability Division of Energy Markets and Reliability or with the Market Oversight Division in the Enforcement Office?

EPAct 2005 requires that "all users, owners, and operators" register with the ERO and comply with mandatory reliability standards approved by the commission. Any project involving power is likely to be subject to these standards and there will be fines, and other consequences for failure to comply. Chairman Kelliher has said: "I can promise that, unlike in the past, if established reliability standards are violated, the violator will be subject to significant civil penalties." Those involved in developing projects here need to add a new dimension to due diligence and to project management to assure they comply with these new rules.

In April 2006, NERC submitted 102 proposed reliability standards for FERC approval. In May 2006, FERC staff filed a "Preliminary Assessment of NERC's Proposed Reliability Standards." Staff found about half the standards to be, for the most part, complete, but added that they might need some improvement. Staff found about a quarter of the proposed standards to be inadequate and the remaining quarter as having inadequate specifics that need to be filled out.

Next on the commission's 2006 reliability agenda is a Notice of Proposed Rulemaking on Reliability Standards, and submissions regarding proposed delegation agreements with regional organizations. FERC intends to approve reliability standards and delegation agreements in early 2007 so that the ERO can begin operations before the summer of 2007. (For more information on this topic, see Spina, Griffen, and Hederman, "NERC's Reliability Standards: the good, the bad, and the fill-in-the-blanks," Public Utilities Fortnightly, Aug. 2006).

Energy market integrity

Over the last several years, FERC has worked to help re-establish confidence in the integrity of the energy markets. Through cooperation and outreach to the financial community, to state regulators, and with sister federal agencies, it has signaled its understanding of the markets and related trading businesses, identified its issues and concerns in a timely manner and shared information when appropriate.

One illustrative example of FERC's success in changing market and investigatory dynamics was the rapidity with which FERC and the Commodity Futures Trading Commission (CFTC) signed a memorandum of understanding (MOU). Congress mandated an MOU between FERC and the CFTC because of Congressional concern about the lack of cooperation between the two agencies with related oversight responsibilities during the early part of the California crisis. FERC and the CFTC signed an agreement within a month of this mandate.

This was possible because the CFTC's director of enforcement had reached out to the new FERC Office of Market Oversight and Investigations when it was formed in 2002, to seek a constructive cooperation. When Congress mandated the MOU, the protocols used by FERC and CFTC staff on investigations during the three previous years formed the basis for a quick turn-around of the MOU.

The enhanced scrutiny of corporate compliance by rating agencies, lenders, and other financiers has also contributed significantly to a return of customer, investor and policymaker confidence in energy market integrity.
In recognition of FERC's progress, EPAct 2005 significantly enhanced the Commission's authority to prevent market manipulation and to punish market participants that violate the Commission's rules (see table above). The Commission views the responsibilities regarding prevention of market manipulation as "important and challenging".

Since EPAct 2005, FERC has signaled a shift in emphasis regarding how to assure market integrity, including re-organizing the Office of Market Oversight and Investigations into the Office of Enforcement. FERC has still not used its new civil penalty authority under EPAct 2005. This authority allows penalties as high as $1 million per day per violation, in addition to traditional disgorgement remedies. Nevertheless, both the chairman and director of enforcement have issued explicit warnings about the Commission's readiness to impose such penalties.

Although those subject to FERC's jurisdiction seem somewhat confused and uncertain about how to interpret FERC's signals and actions, they should not doubt the Commission's resolve. Those who develop effective compliance plans can continue to do profitable business in today's energy markets; those who fail to do so and do not follow FERC's new regulations do so at their own (considerable) peril.

M&A

Another cornerstone of EPAct 2005 is the repeal of the Public Utility Holding Company Act (PUHCA) of 1935 and the enactment of new PUHCA provisions. On a tight schedule, FERC implemented rules on accounting, record retention and reporting mandated by Congress as part of the repeal provisions.

The legislative intent is to remove certain restrictions, such as required contiguity of service areas, from corporate merger initiatives. The shifts in authority regarding mergers and acquisition appear to have enhanced the role of state Public Utility Commissions (PUCs) in these matters.

Project-related opportunities may arise as regulators negotiate asset divestments with corporations seeking merger approval.

Infrastructure

Adequate infrastructure is a key to competitive market outcomes, and the Commission has paid special attention to promoting infrastructure development through investment incentives and siting initiatives.

With respect to investment, FERC has sought to encourage additional investment in natural gas storage by expanding opportunities for market-based rates. Its Hackberry Decision, which preceded EPAct 2005, helped reform open access requirements for new LNG facilities and has promoted significant project interest in this important new energy import segment.

For power transmission, in addition to the reliability provisions (mentioned earlier) that will promote transmission system investment, FERC has provided rate incentives for power transmission investments. On natural gas transmission, there is investor concern now because of an ALJ's decision regarding rates for a pipeline.
FERC staff has also provided strong support for new LNG and gas pipeline projects with regard to accelerating siting/certification time. FERC is preparing to support power transmission siting if the US DOE designates national needs, and the relevant states do not successfully approve transmission to meet the designated needs.

Conclusions

EPAct 2005, and FERC's implementation of it, have changed the landscape of energy markets significantly. The changes have opened significant new opportunities and have introduced significant new risks. Market participants need to take careful account of these changes. This article has summarized major aspects of EPAct implementation, yet there are other items that can be important in particular project deals – for example, changes in PURPA rules and capacity release rules. All of this means that project finance lenders will need to develop new due diligence checklists.

During the excessive exuberance immediately preceding the Enron debacle, due diligence on energy regulation and markets reached serious lows, with lenders forum shopping for consultants willing to generate the most simplistic, positive reports for the lowest fee.

Due diligence practices need to experience the same quantum improvements that energy trading practices have undergone in the last few years. This reform will enhance market integrity and improve market and project performance.